When running an S corporation (S corp), one critical issue that often arises is determining a “reasonable salary” for shareholder-employees. The IRS requires that S corporation owners who actively work in the business pay themselves a reasonable salary, subject to payroll taxes, before taking any distributions. This requirement is crucial to comply with IRS tax regulations. Here’s what you need to know about establishing your S corporation reasonable salary.

Why Reasonable Salary Matters

1. Tax Compliance: The IRS scrutinizes S Corporations to ensure that owner-employees are not avoiding payroll taxes by taking low salaries and high distributions. A reasonable salary helps ensure compliance with tax regulations.
2. Avoiding Penalties: Failing to pay a reasonable salary can result in significant penalties and interest on unpaid payroll taxes.
3. Benefit Eligibility: Paying a reasonable salary may also affect eligibility for benefits like Social Security, which is based on wages earned, not K-1 income.

Factors to Consider When Determining Your S Corporation Reasonable Salary

Several factors influence what constitutes a reasonable salary for an S corporation owner. Here are the key considerations:

1. Industry Standards: Compare salaries of similar positions in the same industry. Research what other businesses pay for similar roles and responsibilities.
2. Experience and Qualifications: Consider the owner’s level of experience, education, and expertise. More experienced and qualified individuals typically command higher salaries.
3. Role and Day-to-Day Responsibilities (Multiple Hats): Assess the nature of the work performed. Owners who take on more significant and higher-value responsibilities should receive higher compensation compared to those who spend a lot more of their time with mundane tasks.
4. Time Commitment: Evaluate the amount of time the owner dedicates to the business. Full-time involvement warrants a higher salary compared to part-time involvement.

Methods to Establish Your S Corporation Reasonable Salary

To determine a reasonable salary, you can use one or a combination of the following methods:

1. Market Comparisons: Use salary surveys, industry reports, and job postings to gather data on what similar positions pay. Websites like Glassdoor, PayScale, ZipRecruiter, and the Bureau of Labor Statistics can be useful resources.
2. Independent Valuations: Hire a compensation consultant or accountant to perform an independent salary study. This approach can provide a well-documented and defendable salary determination.
3. Hybrid Approach: Combine market data with internal business considerations to arrive at a balanced salary figure. This method takes into account both external benchmarks and the specific financial situation of the business.

Documenting Your Salary Determination

Proper documentation is essential to support your reasonable salary determination in case of an IRS audit. Keep detailed records of:

1. Salary Research: Maintain copies of salary surveys, industry reports, and any other research materials used.
2. Role Description: Document the owner’s job duties, responsibilities, and time commitment.

Case Studies and IRS Rulings

Understanding how the IRS has ruled in past cases can provide insight into what constitutes a reasonable salary. Here are a few examples:

1. Watson v. Commissioner: In this case, an accountant paid himself a $24,000 salary while taking $203,651 in distributions. The court ruled that a reasonable salary for someone with his qualifications and workload should have been $91,044, resulting in additional payroll taxes owed.
2. JD & Associates, Ltd. v. United States: A CPA firm business owner was responsible for all of the activities of his firm. The business owner took a salary of $19,000. The IRS asserted that the business owner’s salary was unreasonably low citing his responsibilities as managing partner of the firm. Based on an independent valuation, it was determined a reasonable salary should have been $69,584, resulting in additional payroll taxes owed.

Do You Have to Pay a Salary if You Can’t Afford to?

Conclusion

Determining a reasonable salary for S corporation owners is a critical aspect of tax compliance. By considering industry standards, role responsibilities, experience, and time commitment, you can establish a fair and defensible salary. Proper documentation and understanding of IRS guidelines will help ensure that your S corporation remains compliant and avoids costly penalties.

For personalized advice, consulting with a tax professional or accountant is recommended to ensure that your salary determination aligns with IRS requirements and your specific business circumstances. Included in our service, S Corp Advantages provides S corporation reasonable salary analysis, determination, and documentation. This covers the S corp compliance requirement and keeps you out of trouble with the IRS.